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Types of Bonds

Putting Higher Yields in Context

As with all fixed-income securities, the yield on a fixed-rate capital security represents an estimated annual rate of return and provides a basis for determining the investment’s relative value in comparison to other fixed-income securities. Fixed-rate capital securities typically offer higher yields than corporate bonds or preferred stock from the same issuer. Through the higher yield, the issuer passes along to the investor some of the benefits the structure creates in terms of the issuer’s cost of capital, which is reduced due to the tax deductibility of the issuer’s distributions to investors (unlike preferred stock dividends, which are not deductible for issuers). Furthermore, investors demand a higher yield on fixed-rate capital securities than on other bonds because they permit the deferral of payments and because the securities rank lower than senior bonds in the issuer’s capital structure, and therefore represent a higher degree of risk. The yield advantage over preferred stock exists because fixed-rate capital securities do not offer the tax advantage of the dividends-received deduction that preferred stock provides for corporate investors.

For the investor, these yields are perhaps the securities’ most attractive feature. To fairly compare fixed-rate capital securities to other types of fixed-income investments, however, investors need to consider various yield calculations.

In general terms, yield is a function of a security’s current price and stated interest rate. For trust and debt fixed-rate capital securities, the price used in the yield calculation is usually adjusted to subtract the amount of accrued income included, if any. (See Pricing for more details.)

Like conventional fixed-income securities, fixed-rate capital securities have a current yield based on the stated income payment rate and the current price. They also have a yield to maturity, which assumes income payments will be paid until the final maturity date (typically between 20 and 49 years from the issue date for U.S. issuers), when the principal will be returned. Yield to maturity takes into account the amount of market premium or discount in the price as well as the time remaining until maturity.

For securities trading at a discount, the current yield or the yield to maturity may be the most relevant basis for comparison of one security to another. However, because most fixed-rate capital securities are “callable” by their issuer prior to maturity, the yield to the first possible “call” date may be more meaningful than the yield to maturity, particularly when the price reflects a premium to par value. If an issuer has deferred distributions (see Distributions), the current price may be the best means of evaluating an investment in the security.

The possibility of deferred payments or tax-related “special event” redemptions (see Maturity) may also affect the way an investor evaluates a fixed-rate capital security in relation to other fixed-income investment opportunities. Prior to investment, investors should seek assistance from their account executive to examine the “best case” and “worst case” yield scenarios.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.